This is the third in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: Given recent instances of VC-backed company fraud and questions about the management team, how can institutional investors protect themselves from key person risk?

Answer: You are asking a fundamental question here about trust, which relates to your prior question.  I could restate your question by saying, how do I know that I’ve backed someone as a GP who is trustworthy?  The answer is, you have to do your homework on that person, which means that you have to make a full range of reference calls to people who are not on the person’s reference list.  This takes resources and time.  If you are not equipped with the resources to do the work, then you need to rely on someone else’s process—but again that has to be an independent third party whose due diligence credentials are also trustworthy.

Let me turn the table on you a little bit because I sit in your shoes all the time– as a venture capitalist who bets on entrepreneurs, my greatest challenge is to sit across the table from a very enthusiastic person and judge their credibility—will they actually do what they say they are going to do?  Will they work 24/7 to get the job done?  How will they behave when unforeseen challenges occur—which they always do?  Institutional investors have to do the same thing because they are betting on people, and they need to establish a considerable measure of trust if they are going to sign on to a 10 year commitment to invest in illiquid assets.  This is the toughest part of our jobs—as I look back over my the 14 years I have spent in venture capital as part of my 29 year finance career, the biggest mistakes I have made have always been related to key person risk, as opposed to picking the “wrong” technology.

It’s that time of the year again– time to send out audited financial statements and K-1’s to your limited partners– which means it’s also a great time to address some of the common questions that investors raise about VC partnership governance and disclosure issues.

I recently spent some time answering a series of such questions posed to me by Susan Mangiero, the founder and CEO of Investment Governance, Inc., whose site Fiduciary X, is an emerging “one-stop best practices information portal for investment decision-makers and their service providers.” Fiduciary X, on whose advisory board I serve, combines peer networking, research, productivity tools, proprietary data sets,  and a governance-focused knowledge base with a documents archive to serve fiduciaries and risk managers.

In the interests of sharing this interview with a broad group of interested readers, I am going to be posting one question and my answer each day for ten days, including today.  For access to the full interview, which will be published March 15, please go to the Fiduciary X Ezine registration site.

Question:  How much information are limited partners (pensions, endowments, foundations, etc.) entitled to receive from a VC fund?

Answer: Section 17-305 (b) of the Delaware Revised Uniform Limited Partnership Act, which governs LP information rights according to DE law, specifically allows the GP to withhold from LPs “any information the GP reasonably believes to be in the nature of trade secrets or other information the disclosure of which the GP in good faith believes is not in the best interest of the Fund or could damage the Fund or its business or which the Fund is required by law or by agreement with a third party to keep confidential.”  This would include the GP’s fiduciary duties and confidentiality obligations with respect to not disclosing portfolio company information without the consent of such company.  The Act provides for a specific list of information that LPs are entitled to, and funds historically disclose that same information to their LPs—the top law firms in Silicon Valley model their LP agreement forms to be pretty consistent with Delaware law.

Specifically, Section 17-305 of the Act provides for the following:

(a) Each limited partner has the right, subject to such reasonable standards (including standards governing what information and documents are to be furnished, at what time and location and at whose expense) as may be set forth in the partnership agreement or otherwise established by the general partners, to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner:

(1) True and full information regarding the status of the business and financial condition of the limited partnership;

(2) Promptly after becoming available, a copy of the limited partnership’s federal, state and local income tax returns for each year;

(3) A current list of the name and last known business, residence or mailing address of each partner;

(4) A copy of any written partnership agreement and certificate of limited partnership and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which the partnership agreement and any certificate and all amendments thereto have been executed;

(5) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each partner and which each partner has agreed to contribute in the future and the date on which each became a partner; and

(6) Other information regarding the affairs of the limited partnership as is just and reasonable.

The current state of the art for Agreements of Limited Partnership in venture capital allows the GP to override the information rights LPs have pursuant to the Delaware Revised Uniform Limited Partnership Act (the “Act”) as permitted pursuant to the Act and allows the GP to “adjust” identifying information given to the LPs in order to protect the identity of the Fund’s portfolio companies, which often is an issue in the case of Freedom of Information Act (FOIA) LPs.  In addition, the partnership agreement allows the GP to restrict / withhold information from LPs if “the General Partner reasonably determines [such LP] cannot or will not adequately protect against the [improper] disclosure of confidential information, the disclosure of such information to a non-Partner likely would have a material adverse effect upon the Partnership, a Partner, or a Portfolio Company.”  Other elements of the well drafted agreement do provide the LP’s with disclosure rights to their advisors, equity holders, etc. and provide remedies and protections to the GP with respect to GP withholding rights and improper LP information disclosure.

I recently chaired a panel at the Stevens Institute of Technology cybersecurity conference in Washington D.C. and was asked by the conference organizers to develop an agenda based on a review of pending Senate Bill 773, the “Cybersecurity Act of 2009″.  Our panel, which included two security experts– former National Security Agency Deputy Director Bill Crowell and Ted Schlein of KPCB, focused on some of the challenges to the passage of effective legislative solutions aimed at securing data on the Internet. The point of departure for our panel was a consideration of two specific sections of Senate Bill 773.

The summary of the Bill’s purpose highlights the importance of the continued free flow of commerce, the need for secure cyber communications on the Internet, and a defensive approach to prevent disruption to these activities.

Three focal themes emerged from the discussion:

I That the implementation of effective international standards of cooperation to achieve cybersecurity is going to be more difficult to achieve and is far more complex than it appears. Google’s unfolding experience in China is only the latest manifestation of the complexity of this issue.

II That developing a new legislative protocol for the dissemination of cybersecurity threat information to the public is going to be very difficult and is likely to lead to unintended consequences.  While one government organization may be designated as responsible for this delicate role, many others will continue to lay claim to ultimate authority over what is or is not classified information in the cyber realm.

III That legislative approaches to cybersecurity need to more fully recognize that promoting healthy and robust U.S. capital markets is essential to our nation’s economic and national security.

The globally integrative power of the Internet brings with it major challenges when it comes to international cooperation.  This is especially the case when the economic competition between nation states is increasing and different players approach the same playing  field with completely different rules as to what constitutes fair play. Bill 773 designates the President to develop norms, organizations, and other cooperative activities for international engagement to improve cybersecurity.

What do we mean by different approaches to economic competition? McAfee recently released its fifth annual Virtual Criminology Report, concluding that politically motivated cyber attacks have increased in a number of countries, including the United States. There is a clear tension between the desire and need for international cooperation and setting standards in cybersecurity and the reality that cyber attacks are now a tool of governments.

Bill Crowell was quoted in that report as saying that “Over the next 20 to 30 years, cyber-attacks will increasingly become a component of war,” “What I can’t foresee is whether networks will be so pervasive and unprotected that cyber war operations will stand alone.”

In section 14, Bill 773 designates the Department of Commerce as the clearinghouse of cybersecurity threat and vulnerability information to the Federal government and the Private sector.  The protection of our nation’s critical infrastructure is a matter of both economic and national security.  This is also probably one of the most sensitive “political turf” battle issues in the United States.  The Department of Defense, the NSA, various military branches, and the intelligence community all lay claim in various ways to a piece of the cybersecurity pie. Nobody will argue that a breach of our nation’s cybersecurity impacts commerce.  Can you explain why the Department of Commerce has been designated to serve as the clearinghouse of cybersecurity threat and vulnerability information to Federal Government and private sector owned critical infrastructure information systems and networks, and how do you believe this is actually going to work in terms of coordinating with the military?  What happens when someone invokes making threat data classified as a matter of national security—aren’t we already living in ignorance of a lot of threat information precisely because of this problem?

Click here for a link to the full panel broadcast, which was broadcast on C-Span.

Startups, the engine of American innovation and an important source of job growth nationally, took a severe beating in 2009 because so few were funded by the venture community. While the freedom to fail remains a given among emerging companies, a creeping risk aversion among investors inhibiting new capital formation for long-term, illiquid investments threatens an entire generation of American entrepreneurs.

This should be particularly unnerving to our elected representatives because strong startups have proven their ability to grow rapidly and produce jobs, particularly if they go public. Public companies such as Google, Cisco and Intel, all initially venture-backed, today represent 17 percent of U.S. gross domestic product and have created a total of more than 12 million good jobs. The most important startup centers are Silicon Valley, metropolitan Boston, Seattle and Austin and, increasingly, northern Virginia.

Many venture capitalists and other capital markets experts believe that 2010 will be a better year for achieving IPO liquidity because a number of well established companies that remain private have reached sufficient scale to attract much-needed public equity funding. But this is a small minority of the venture-backed universe, and the majority of fledgling technology companies continue to face existential challenges. A significant but largely unheralded problem for many is that they are managed poorly at the highest levels, and this lack of stewardship can lead to a company’s demise.

About two-thirds of CEOs who initially take the top job at a startup are eventually replaced, but many venture capitalists approach the likelihood of management change as an afterthought, even though driving an orderly process for management succession represents the venture capitalist’s most important role as a corporate director. Much of the explanation for this surprisingly common problem can be traced to misaligned interests between the board and the CEO, a situationthat is only aggravated by stressful economic times.

While most startups experience CEO change as they evolve into a self-sustaining company, venture capitalists who sidestep the process associated with this managing reality set the stage for operational turmoil and key personnel defections.

I believe venture capitalists and CEOs must put their differences aside so that these startups can survive and ultimately thrive. Among the reasons for the differences of approach to managing CEO change among venture investors is that early-stage players often forge a strong personal, as well as business relationship, with the CEO. This relationship is often absent among later-round venture investors. And the issue of equity dilution, always high on the CEO’s agenda, often clashes with the agenda of all venture backers. Things get even hotter when a startup fails to meet projections, requiring more capital than originally anticipated, an all-too-common scenario today.

Many founders find it particularly galling to be found wanting in their management skills at precisely the time that their fledgling companies experience rapid revenue growth and markedly improved performance. The sweat they have poured into the research and development phase is the foundation for the company’s budding success. Many founding executives view the situation as one of betrayal by their venture backers, sparking the collateral damage mentioned above.

Much can be accomplished to mitigate these stresses if startup boards and CEOs become more transparent and put sound management strategies into place.

It isn’t particularly difficult to turn this situation around. Venture capitalists need to take a proactive approach and manage toward the reasonable expectation of CEO change from day one. This means engaging CEOs in a frank discussion of their strengths and weaknesses, constantly assessing CEO performance, and forging a relationship with the CEO-founder that can transcend a management change. This creates a win-win for both parties. The outcome could be a new role for the founder, preserving his ability to make a productive contribution to the company.

Venture capitalists also must stop ignoring clear early-warning signs that the time has come to replace the CEO.

Here are five common early warning signs of trouble in the corner office:

• A CEO does not react constructively to board member suggestions, is increasingly inflexible in considering strategic board changes, or stubbornly clings to a plan that is not working.
• Significant company problems are obvious but the CEO goes into denial, sometimes by seeking seats on outside boards, scheduling frequent vacations, or getting involved in political, community or charitable endeavors. A CEO often missing-in-action because of these activities has usually lost the requisite “fire in the belly” that a venture-backed startup CEO needs.
• The CEO cuts off the flow of information to the board and typically initiates few calls to board members. Typically, every director should hear from a CEO in advance of board meetings, as well as once or twice a month to celebrate good news, discuss a setback, or simply discuss a basic management issue.
• A CEO increasingly pleads ignorance of a problem, complaining that other executives did not keep him informed. But the CEO doesn’t present a clear case and a plan to remedy the situation or tries to toss problems back in the board’s lap.
• A CEO starts referring inquiries from board members to other executives as a loyalty test, putting out the word that no executive is to communicate with a board member without first getting approval from him. It’s a red flag when subordinate executives give board members scripted, vague answers in response to questions.

Venture capitalists and other members of startup boards must become much more involved in their assessment of the company’s long-range strategy. To do this, they have to first learn to work better together through more frequent communication, both in and out of the boardroom. They must master the art of compromise in the boardroom and focus on the real goal – maximizing the odds of success of their startups. This is imperative for America as startups and venture capitalists begin a new and pivotal year.

The current issue of Foreign Affairs features an important essay by Wesley Clark and Peter Levin (see bios below), Securing the Information Highway- How to Enhance the United States’ Electronic Defenses.  General Clark and Mr. Levin not only succinctly summarize the fact that America remains “an easy target”, especially for “electronically advanced adversaries”, they spend a considerable amount of time on the topic of supply chain assurance and the massive challenges associated with securing computer chips– the true guts of our nation’s IT hardware critical infrastructure.

At the outset, the authors affirm a stark reality:

“There is no form of military combat more irregular than an electronic attack: it is extremely cheap, is very fast, can be carried out anonymously, and can disrupt or deny critical services precisely at the moment of maximum peril. Everything about the subtlety, complexity, and effectiveness of the assaults already inflicted on the United States’ electronic defenses indicates that other nations have thought carefully about this form of combat. Disturbingly, they seem to understand the vulnerabilities of the United States’ network infrastructure better than many Americans do.”

The most challenging part of the cybersecurity assurance equation from their perspective, with which I agree, is verification at the integrated circuity (IC) level:

“At the rate of one transistor per second, it would take one person 75 years to inspect the transistors on just two devices. . . . finding a few tainted transistors among so many is an exceedingly tedious, difficult, and error-prone task, and in principle an entire electronic system of many chips can be undermined by just a few rogue transistors. … An apparently perfect device can provide a safe harbor for numerous threats– in the form of old and vulnerable chip designs, Trojan horses, or kill switches– that are difficult or impossible to detect.”

Turning to solutions, the authors make a compelling case for an open-source approach to creating an immunization system for U.S. networks, an approach that is very different from the current path that the U.S. is following.  They also point to the fact that a significant tactical advantage enjoyed by adversaries planning cyberattacks on the U.S. is due to two factors, principally  “Americans’ false sense of security: the self-delusion that since nothing terrible has happened to the country’s IT infrastructure, nothing will.”  Second only to this, they point out that “the passage of time will allow adversaries and cybercriminals to optimize the stealth and destructiveness of their weapons; the longer the U.S. government waits, the more devastating the eventual assault is likely to be.”

I strongly support their assertion that “in addition to building diverse, resilient IT infrastructure, it is crucial to secure the supply chain for hardware.”  They make the very important point that “it makes sense now– just as it made sense during the Clinton years– to purchase components, even those made offshore.  The problem is not foreign sourcing; it is ensuring that foreign-made products are authentic and secure.”

While they do not mention it explicitly, the authors clearly are calling attention to the flawed logic behind the United States’ Trusted Foundry program, which is based on the assumption that only IC’s fabricated on U.S. soil can provide 100% assurance.  The U.S.  ceded the center of gravity in the semiconductor fabrication industry to Asia many years ago.  With 17% or less of the global semiconductor fabrication infrastructure physically in the U.S., and with inherent cost disadvantages relative to international competition in the pricing of IC’s, hardware assurance for critical infrastructure in the U.S. can only be achieved through innovative and collaborative efforts that are  international in scope.

The authors conclude, and I agree, with the following:

“Unfortunately, much of the relevant information, such as DARPA’s TRUST in Integrated Circuits program– is classified. Confidentiality will not necessarily help ensure that the nation’s information assets are well protected or that its cyberdefense resources are well deployed. In fact, because many of the best-trained and most creative experts work in the private sector, blanket secrecy will limit the government’s ability to attract new innovations that could serve the public interest.  Washington would be better off following a more ‘open-source’ approach to information sharing. “

WESLEY K. CLARK, a retired four-star General, was Supreme Commander of NATO from 1997 to 2000, led the alliance of military forces in the 1999 Kosovo War, and is a Senior Fellow at the Ron Burkle Center for International Relations at UCLA. PETER L. LEVIN was the founding CEO of the cybersecurity company DAFCA and is now Chief Technology Officer and Senior Adviser to the Secretary at the Department of Veterans Affairs. The views expressed in this article do not necessarily represent the views of the U.S. government.

Everybody has an agenda, and we are all influenced by our personal experiences and biases. In reading many of the media reports after the release of the Grant Thornton study, A Wake Up Call for America, I have seen both thoughtful commentary in publications such as The Economist and the Wall Street Journal, as well as dismissive reports by some who find that the Grant Thornton study’s facts inconveniently stand in the way of their own agendas.

Certainly the ‘High Frequency Trading’ community of dark pools and hedge funds that currently account for 70% of daily trading activity in the U.S. don’t like this report.  Why?  Because reports like this stand in the way of financial market manipulation and drive home the point that not all financial innovation is good and that stocks are not fungible commodities.  The rapacious credit derivative and mortgage market financial engineers should have succeeded in proving the dangers of ‘one-size-fits-all’ thinking– to the world’s great detriment. Fortunately, responsible legislators who do show leadership, such as Senator Ted Kaufman (D) Delaware, are willing to call out the systemic risks of high frequency trading in publications ranging from the Financial Times to the Delaware News Journal .

And then there are those who look at the broken U.S. IPO market and simply dismiss the American equity markets for emerging growth companies today as “no longer engineered for brokers & bankers to make money via flipping over-valued startups to retail investors via institutional cronies”(from Paul Kedrosky’s blog).  I strongly disagree with this point of view.  It is  a fact that the lack of IPOs is harmful to job creation and to the American economy. Compounding the IPO drought is the fact that the entire NASDAQ market has shrunk—since December 2000 the NASDAQ has contracted by 38% to approximately 1,786 companies. So not only are fewer companies going public, more companies have been forced to merge or have gone out of business, which means there are fewer public companies to acquire other emerging companies. This is a very unhealthy situation, but it has been allowed to continue for years.

Again, the facts show that small growth company IPO’s can grow into global powerhouses–  the IPOs of Applied Materials, Adobe, Dell, Intel, Symantec, BMC, Computer Associates, EA, EMC, Fiserv, Intuit, Net App, Oracle, Paychex, Western Digital, Xilinx, and Yahoo!, which happen to all be venture‐backed companies, went public raising less than $50 million at various times between 1971 and 1996. These companies raised just $367 million in the public markets, and they account for 470,000 U.S. jobs today. Adjusted for inflation and measured in 2009 dollars, the $367mm in total dollars raised by this group equals $670mm, and only 2 of these 17 companies’ IPOs (EMC $80mm and Oracle$70mm) exceed $55mm in 2009 dollars. While today these companies are household names, let’s not forget that these companies were also largely unknown small cap growth companies when they first went public and that this impacts the entrepreneur most of all—how many companies that represent the next generation of household names will be still-born or acquired into obscurity because they cannot access the public capital markets today?

The IPO drought is a symptom of a deeper systemic liquidity crisis for small capitalization companies. Predictions that U.S. IPOs are about to come back in a meaningful manner are wishful thinking. The current threshold criteria for liquidity as defined by the dominant underwriters in the U.S. accommodate only a small minority of the viable private companies seeking public growth capital.  The severity of this untenable situation is compounded by a general lack of awareness among our nation’s policymakers that all of these factors are interrelated.

Today, if we are lucky enough to actually be in the aftermath of the global financial crisis, the risk capital available for market markers and small cap company underwriters to support America’s innovative entrepreneurs has diminished significantly.

The Grant Thornton report’s greatest value is in its thorough analysis, as it proves without a doubt that the U.S. capital markets for listed equities have been in systemic decline since 1997.  This condition is clearly not the result of the technology bubble or Sarbanes Oxley. Most importantly, the absence of U.S. IPOs negatively impacts American entrepreneurs most of all, regardless of whether they have venture capital or private equity backing.

The current IPO markets in the U.S. are not in equilibrium, and we are seeing this proven by the increasingly robust and growing offshore markets for new listings. Innovation is global, and risk capital is mobile.  Our country will continue to suffer the consequences of this trend as long as positive economics for supporting small cap companies in the market are absent.  Rational economic actors do not continue to risk capital in a loser’s game.  While this impacts venture capital exits, it isn’t about venture capital, it’s about capital markets.

The successful launch on October 30, 2009 of the Shenzhen GEM market for small cap companies, raising $20 billion for 28 small cap companies in one day, proves the point.  China leads the world in IPO’s in 2009; it would be a serious mistake to dismiss this as a flash in the pan or a “casino”. Risk capital will go where it is rewarded, and currently that is not in the United States.  Be careful what you wish for…

Aline van Duyn of The Financial Times reports that the U.S. listed capital markets have been in systemic decline for many years, quoting the forthcoming Grant Thornton study which will be released November 9th:

The analysis finds that the number of US exchange-listed companies is down by more than 22 per cent since 1991 and down by 53 per cent when allowing for real, inflation-adjusted gross domestic product growth.

In Asia, growth in listed companies is increasing faster than the GDP growth rate, and the pace far exceeds that of the US.

“This [decline] is not a global phenomenon; the US is seriously lagging other industrialised nations in the formation of such listed companies,” the report says.

The analysis, which has been in the works for more than six months, argues that the structure of the US financial markets is no longer configured to support the capital raising activities of small start-ups.

To read the full article CLICK HERE

United States Senator Edward Kauffman (D) Delaware wrote a very important opinion piece in last Friday’s Financial Times,  shining a light on the opaque technical trading regulations which are the root cause of the IPO drought in the United States, threatening the integrity of our markets and putting at risk an entire generation of innovators.  Senator Kaufman’s article is insightful, concise, and clear.  I applaud his important leadership in this complex and critical area.

For a link to the article, click HERE.

I have re-printed it in its entirety and urge you to read it below:

Preventing a horror movie ending in the US markets
By Edward E. Kaufman

High frequency trading, dark pools, and flash orders – unknown to most Americans a few short months ago – have now joined the American lexicon. As phrases, they are easily tossed about. But trying to understand the arcane, high-tech and labyrinthine way stocks are traded – radically transformed from just a few years ago – is far more difficult.

Many on Wall Street assure us there is nothing to worry about. In their view, the dramatic proliferation of competing markets and the extraordinary rise in high velocity trading have had only beneficial results: greater liquidity, narrowed spreads and lower transaction costs for all investors.

Lost in this reflexive defense against meaningful government review, however, is a more overarching concern: the integrity of our capital markets, which are now too fragmented, too opaque and well beyond the effective surveillance of the Securities and Exchange Commission.

That’s why I have urged the SEC to undertake a comprehensive “ground up” review of a broad range of market structure issues before more piecemeal changes occur. We have seen this horror movie before, and only timely regulatory examination can best prevent a sequel: When markets develop rapidly and are not transparent, effectively regulated or fair, the movie’s ending scene can be one of tragedy affecting millions of people.

The facts speak for themselves. We’ve gone from too few stock markets to too many; from an era dominated by a duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented market of more than 60 trading centres.

In competing for market share, those trading centres encourage or permit a variety of questionable practices. Dark pools, for example, which allow confidential trading that takes place away from the public eye, have flourished: Five years ago, there were 18 dark pools comprising 1.5 per cent of the market’s volume; today, over 50 dark pools execute over 12 per cent of market trades. And the total percentage of trades taking place in dark pools or internally at broker dealers, another source of private trading outside public markets, now approaches one quarter. For strictly retail investor orders, it may be twice that amount.

Moreover, in just two years, the percentage of daily stock trading volume by high frequency traders – whose computers are constantly probing the market for miniscule price advantages — has reportedly skyrocketed from 30 percent to nearly three out of every four trades.

Left unchecked, high frequency trading could develop into a systemic risk, becoming simply too big and too fast to regulate. If all the machines “zig” at the same moment when they should have “zagged”, market chaos could ensue.

And when the average investor loses confidence in the integrity of our markets, when he or she believes that the price at which they are able to buy 100 shares of IBM is higher than it should be, even if only marginally, because of high frequency gaming strategies, then the reputation of our capital markets for basic fairness is significantly tarnished.

The SEC’s review should be all-encompassing, reviving old ideas and examining new ones: should markets be centralised or decentralised; should we separate the markets based on investor types; what should be the role of market makers; what role might there be for real time risk management?

At a minimum, a few simple themes should guide us to a regulatory framework that permits vigorous competition while substantially reducing the possibility of a two-tiered trading network, where long-term investors are vulnerable to powerful trading companies that exist not to value or invest in the underlying companies, but to feed everywhere on small but statistically significant price differentials.

First, we should reconsider the criteria for becoming an exchange or market centre because the market’s unhealthy fragmentation – and the high-speed trading strategies that thrive on it – are growing rapidly.

Second, we should consider rule changes that ensure the best prices are publicly available, not hidden from view in private trades. The strength of a free market is based on this public display. Accordingly, we should reduce “internalisation” (by insisting on meaningful price improvement in comparison to the public quotes or by granting the public quotes the right to trade first) and trading in dark pools (by reducing the permissible threshold for dark trading and defining indications of interest, and other quote-like trading signals, as quotes).

Third, we should root out conflicts of interest by ending payments from market centres that encourage orders to flow their way. The search for best execution by broker-dealers should not be subject to temptation from the highest bidders. Competition for market share includes liquidity rebates and direct access for hedge funds, which also deserves careful review.

Fourth, until regulators can measure execution fairness in milliseconds for stock trades of all kinds, the credibility of the markets cannot be assured. The audit trails and records of order execution in fragmented venues must be synchronised to the millisecond and made readily available in statistically understandable formats to the regulators and the public. Currently, while high frequency traders bank profits in milliseconds, the first column for time on the Rule 605 form, used by regulators to measure execution quality, reads “0-9 seconds.”

Fifth, regulators must also develop more sophisticated statistical tests, such as following volume patterns to gain a granular view of gaming strategies. Only then can regulators separate high frequency strategies that add value to the marketplace from those that inexcusably take value away.

As a nation, our credit and equity markets should be a crown jewel. Only a year ago, we suffered a credit market debacle that led to devastating consequences for millions of Americans. While we must redress those problems, we must also urgently examine opaque and complex financial practices in other markets, including equities, before new problems arise. It is essential to ensure the integrity of US capital markets.

Edward E. Kaufman is a Democratic senator for the state of Delaware

Decimalization, quoting stock prices in decimals instead of fractions, isn’t a problem in and of itself.  The problem results from turning a market spread that used to be $0.25, for example, into 25 1-penny increments because it takes the positive economics out of trading that stock for market makers who are supporting relatively unknown emerging growth  small cap companies.  Why does this matter?  Because if you can’t make money risking your capital by providing liquidity for others, you won’t.  This change to decimalization occurred in 2001. Combined with New Order Handling rules originally passed in September 1996 and implemented in 1997, these modifications to technical trading rules fundamentally changed how then-emerging electronic trading networks (ECN’s), such as Instinet, could buy and and sell stocks. In short, ECN’s could transact within the market maker’s spread and force the market maker to execute at the ECN’s order price.  The problem with this, again, is that it caused market makers to lose money, so they stopped marking markets in stocks where they would lose money.  Simple enough, but the unintended consequences of well-intended regulations have had the severely negative impact on our economy of gutting liquidity and research support for small cap stocks.  As a result, small companies that are otherwise worthy of going public cannot access the public markets because they cannot support a large enough underwriting to attract large cap investors.  This is why the underwriting criteria for IPOs today require companies to have $100mm plus in revenues, have a multi-year history of positive cashflow generation, and be profitable on a GAAP basis, at a minimum, in order to raise sufficient capital to generate sufficient after-market liquidity for underwriters to take on the new listing.  The losers are the next generation of innovative companies and the entrepreneurs who lead them– today’s version of Intel, Dell, EA, Applied Materials, Symantec, Oracle, and many other well-known companies who could not meet today’s IPO criteria but did successfully go public and grow into industry giants through IPO’s completed before 1997. Watch this Bloomberg TV video, featuring David Weild, which tells the story. CLICK HERE FOR VIDEO LINK

I’ve posted the text of my prepared remarks integrated with the PowerPoint slides on the web and am proudly wearing my “wet blanket.” While many analysts of the impact that the capital markets crisis is having on emerging growth companies focus on describing the problem, I have added my voice in support of a group of capital markets experts who are proactively offering concrete and realistic solutions to the problem.  More to follow…

CLICK HEREto access the pdf.

I invite comments from others who feel that the capital markets are in need of systemic reform and have actionable recommendations to restore the job creating engine that is the small company IPO.